Fractional reserve produced money IS debt free.

Advocates of full reserve banking sometimes claim that a defect in fractional reserve is that it involves paying interest in order simply to have enough money to do business: to effect normal day to day transactions (never mind borrowing).

And that is a plausible argument. After all, assuming no monetary base (i.e. central bank money), all money would be supplied to the population by fractional reserve banks. And fractional reserve banks, as we all know, “lend money into existence” and charge interest for doing so. So it might seem that banks charge interest simply for providing a money supply. But there is a flaw in that argument as follows.

Assume an economy where the population wanted just enough money in order to do business, but did not want to borrow (at least not from banks). People would ask banks to credit their accounts and people would supply banks with collateral.

However banks in that scenario would not themselves need to borrow money: they would not need to pay interest to anyone to obtain the money (in the same way as banks in the real world, if they don’t want to lose reserves, have to cling on to their depositors and/or get money from bondholders and/or from the wholesale money market).

In that hypothetical scenario, banks would simply charge for administration costs and for the normal sort of profit that any business expects to make.

Thus IN AS FAR AS fractional reserve banks simply supply the economy with money, as distinct from lending, the population do not pay any interest in order to obtain money.


Administration costs.

As to costs, it might seem that central bank provided money is cheaper than commercial bank provided money. Reason is that where a central bank provides the money supply (which is what full reserve amounts go), there are no administration costs worth talking about and no collateral is needed.

Central banks do of course incur costs, but those costs are costs that are for the most part being born anyway. That is, whether central banks provide a large or small proportion of the money supply, they are still into the business to issuing money and withdrawing it depending on whether stimulus or the opposite are needed. For example, they’ve been issuing money big time over the last two years or so under the guise of QE.

This it might seem that the ADDITIONAL costs involved in having central banks supply ALL MONEY are small.
However, a similar argument applies to commercial banks, and as follows.

Assuming commercial banks are into the business of lending IN ADDITION TO providing the money supply, the ADDITIONAL costs of providing that money is probably small. To illustrate by reference to typical household, if a household wants to borrow £50,000 for a mortgage, and wants an additional £2,000 as a float or “petty cash” for day to day transactions, the additional costs of supplying that £2,000 will be marginal costs, as distinct from the inevitable FIXED COSTS that are involved in arranging a mortgage, big or small.

But having said that, my hunch is that a central bank can supply an economy with money more cheaply than commercial banks: that is, I’d guess the additional administration costs per person in having the central bank create and spend a few billion extra into an economy are less than fiddling around with mortgages, collateral, etc.

So how do commercial banks manage to knick the seignorage business from central banks? For the answer see here.


Central bank base rates.

There might seem to be a weakness in the above argument as follows. I said that where fractional reserve banks supply all the money, and people do not want to borrow from such banks, there is no need for those banks in turn to borrow.

There is of course an exception: where the central bank wades into the market and imposes an interest rate above the free market rate. However, while I favour independent central banks, the latter activity is a “non-free market” activity: central banks can only engage in that non-free market activity because they are backed by government, the police, the army, etc.

Fractional reserve banks should be prosecuted under the trades description act.

If a casino told its customers they’re guaranteed to win, or get their money back, the casino would be prosecuted in Britain under the Trades Descriptions Act, and under similar laws in other countries.

 But a bank can make virtually the same promise to its depositors, and no prosecutions ensue. To be exact, banks accept deposits, promise to return the money to depositors while investing the money in ways that are a bit of a gamble: ways that mean there is a chance of losing the money, or a portion of it.  That is a false prospectus.

 Of course well run banks don’t fail all that often. But the reality is that nowhere near all banks ARE run responsibly. They never have been and they never will be. Moreover, banks spend VAST SUMS bribing or persuading politicians to water down bank regulations. (In the UK, banks spend £93million year on lobbying). Thus the idea that the bank industry is honest or “responsible” is a joke, and a joke in very poor taste.

But even where a bank IS well run, it’s a statistical certainty that sooner or later it will make a string of bad loans or investments, and get into trouble.

In short, fractional reserve is fraudulent. It makes a promise which in the long run it can’t keep.

So to get round this, taxpayers stand behind the above fraudulent promise. Or put another way, fractional reserve cannot work without a taxpayer funded subsidy. But THERE IS NO EXCUSE WHATEVER for subsidising an industry which is supposed to be commercially viable.  And the subsidy of our existing banking system is ASTRONOMIC. Andrew Haldane of the Bank of England estimated it as being several times bank profits over the last decade or so. So the idea that the banking industry is commercially viable is a joke.

Of course there is the possibility of some sort of annual levy or “insurance premium” imposed on banks which might pay for sorting out problem banks. That works where one or two small banks go bust. But in the case of several large banks, the sums involved are so large that only the state or central bank can effect a rescue.

Incidentally unit trusts (“mutual funds” in the US) engage in much the same activity as banks, but without making the above fraudulent promise. Unit trusts, like banks, take money from depositors / investors, and like banks, they invest the money. But they DON’T MAKE the same fraudulent promise that banks make. That is, unit trusts are perfectly open about the fact that depositors / investors may lose money.

The solution.

Fractional reserve banking involves a bank monetising the assets of those who want to borrow.

But the problem (as intimated above) is that the value of the collateral is not always what it seems (think Spanish and Irish property development, NINJA mortgages, etc).

The problem arises because the above process involves no one taking responsibility for all potential losses. So the state ends up carrying the losses. Thus the solution is to make specific people responsible for ALL POSSIBLE losses: that’s bank shareholders, bondholders and depositors. And that’s what full reserve banking involves.

Central bank money.

It was claimed above that the basic activity of commercial banks is to monetise the assets of borrowers. That money is then of course moved by banks between different non-bank entities on instruction from those entities and as a way of paying for goods and services.

However, commercial banks actually deal in another sort of money: money that originates with central rather than commercial banks.This stock of “central bank” money is a small proportion of the total money supply, but for the sake of accuracy it cannot be totally ignored.

The principles that need to be applied under full reserve to this central bank money are actually just the same as are applied to money originating with commercial banks. The principles are thus.

If a depositor wants their money to be 100% safe and/or instant access, the money cannot be loaned on. If it WERE loaned on, then two entities than have a claim to the same tranche of money. Or put another way £X is turned into £2X. Money creation has taken place. Moreover, if the money is loaned on, the money is then not 100% safe.

And since such money is not doing anything, it won’t earn interest.

In contrast, if a depositor wants to earn interest, then the money IS LOANED ON. But the depositor cannot have instant access to the money, else again, money creation takes place. Plus the depositor must take a hit if the underlying loan or investment goes bad (and/or share in the profits if the underlying investment does well). And that latter stipulation is needed because if the depositor does not carry the risk, then the taxpayer does, thus a subsidy is involved.

The banks’ answer.

The answer given by banks to the above argument is entirely predictable: they claim that restraints in bank activity has a deflationary effect, or restricts economic growth. And 99% of politicians and about 50% of economists fall for that sob story. Suckers and mugs the lot of them!

The UK’s Vickers commission fell for this nonsense. Same goes in other countries (Basle, Dodd-Frank, etc).

Obviously any restriction on bank activity is deflationary ALL ELSE EQUAL. But all else does not need to be equal. That is, the above deflationary effect can be countered simply by having the central bank / government create and spend extra money into the economy (and/or cut taxes). That gives all participants in the economy (households, firms, etc) an extra stock of cash, and if the size of that extra stock is correct, it will counteract the above deflationary effect.

Indeed, removing a subsidy from any type of economic activity IS BOUND TO result in less of that particular activity. And that in turn will necessitate the expansion of some similar and alternative activity: exactly what giving non-bank entities a bigger stock of cash achieves.

Nonsense from Alan Greenspan.

We plebs have always known that the top positions in most countries are occupied by idiots. This passage authored by Alan Greenspan confirms the point. He starts:

“In the absence of the gold standard, there is no way to protect savings from confiscation through inflation.  There is no safe store of value.”

Whaaat? So Greenspan has never heard of inflation proof “stores of value” like shares, houses, land, inflation proof government bonds, etc? Hilarious.

Of course he is right in that absent the gold standard there is no HIGHLY LIQUID and inflation proof store of value. But what of it? Who wants to keep a large proportion of their assets in a highly liquid form? The VAST MAJORITY of ordinary people hold the vast bulk of their wealth in very illiquid assets like their house and car.

If there are a few billionaires who can’t think of anything to do with their wealth other than hold vast amounts of cash which is eroded by a small amount annually by inflation, I just couldn’t care less. In fact a modest amount of inflation is a brilliant form of tax: it robs stupid rich people who can’t think of anything to do with their wealth.

Greenspan continues:

“If there were (an inflation proof store of liquid assets) the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.
This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.”

No, “deficit spending” is not “simply a scheme for the confiscation of wealth”.

Of course grossly excessive deficit spending which results in rampant inflation results in a form of theft: in that scenario it’s not just billionaires who are seriously inconvenienced – ordinary people are as well. But advocates of deficit spending do not advocate rampant inflation.

For the benefit of Greenspan and any other economically illiterate central bankers, the purpose of deficit spending is to bring full employment – though perhaps ensuring ordinary people have jobs is not high in the list of Greenspan’s priorities.

Of course a more or less continuous deficit decade after decade DOES BRING continuous inflation (assuming the deficit is larger relative to GDP than productivity improvements). But that decision to go for a 2% or so rate of inflation stems from the view, accepted by about 90% of economists, that 2% inflation (rather than 10% or minus 16% or any other figure) is about optimum. To that extent, the DEFICIT is not the fundamental cause of inflation.

Put another way, we could very easily achieve zero percent inflation even in the absence of a gold standard. It would be easiest thing in the world to do, though the price would be higher unemployment.  Well I could do it, though whether Greenspan could do it is more debatable.

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Hat tip to Stephen Williamson: http://newmonetarism.blogspot.co.uk/2012/09/alan-greenspan-and-gold-standard.html

Amazingly unoriginal new theory: “Endogenous Money”.

Thanks to Philip Pilkington for explaining how our monetary system works: in particular the fact that private banks create money. However he rather suggests the latter idea is new.

Advocates of full reserve banking actually worked out long ago that private banks create and destroy money. For example Irving Fisher (an advocate of full reserve) said in the 1930s in his booklet “100% Money and the Public Debt” that, “At present our nation’s chief money is at the mercy of the mob rule of 15,000 banks. These are tantamount to 15,000 private mints independently creating and destroying the nation’s money every day, while the Government looks on helplessly at this usurpation of its prerogative.”

And the London goldsmiths who in the 1700s issued receipts for non-existent gold doubtless realised they were creating money, as did their customers.

However there are plenty of economics text books that have not cottoned on to what is going on here, and Philip Pilkington is right to point to the deficiencies of those text books.

Rogoff’s debt “overhang”.

Rogoff and the Reinharts recently published a paper entitled “Public Debt Overhangs…”. They rarely use the word debt without the suffix “overhang”. You’re supposed to imagine yourself under a cliff with “debt” hanging over you and about drop on your head.

I suspect it says something about the weakness of their arguments that they employ that sort of propaganda.

They claim debt to GDP ratios over 90% tend to lead to low growth for the next decade or two. The tendency is not a strong one, but I have no quarrel with their claim that the tendency is there.

As to possible CAUSAL effects running from large debts to poor growth, they offer just one possibility namely that those debts crowd out private investment, either via a quantitative effect or via a price effect (i.e. large government borrowing raises interest rates).

As to the interest rate effect, they themselves say (p.83) that there is little relationship between high interest rates and growth. So that rules out the price effect.

As to the quantitative effect, that is a possibility.

However, there is simpler explanation as follows. Politicians and a significant proportion of the economics profession just don’t understand deficits, debt, and so on. That is, most politicians and too many economists see national debts and deficits as working in the same way as household debts and deficits. I.e. the latter individuals just don’t understand macroeconomics – or at least macroeconomics as it applies to national debts and deficits.

To expand on that, the above misguided individuals think the best way to reduce national debts is to raise tax or cut public spending, in the same way as a household has to raise its income or cut its spending if it wants to speed up the reduction in any debt it owes. (We must be thankful that at least Rogoff & Co don’t fall into that trap.)

And of course the result of that crude application of microeconomics at the macroeconomic level is to bring about a reduction in demand: it condemns an economy to operating at below capacity.

Moreover, about half of the countries and periods of elevated debt examined by Rogoff & Co were in the pre-Keynsian era. That was an era in which the above “crude” thinking was dominant. So there is possibly a very simple explanation for the “high debt leads to low growth”: ignorance on the part of the elite.

Unfortunately we are in danger of returning that at “crude” era, as Krugman points out.

Or rather, we’re already there. Why are there millions more unemployed in the U.S. than there should be? Reason is that about 95% of members of Congress don’t understand the above macro/micro point. Nor do politicians in other countries. Plus Republicans and Democrats are more interested in squabbles which involve the unemployed being caught in the cross fire than doing anything about the unemployed. Or as former defence secretary Robert Gates accurately put it, they are more concerned with “scoring ideological points than with saving the country”. (h/t to Mike Norman)

That’s not to say that Keynes’s ideas are necessarily the best solution and that structural facts might not be the main explanation of high unemployment (though I suspect that structural factors are NOT the explanation). The point is that even if it was 100% clear that structural factors were not the culprit, the West’s politicians would still make a hash of trying to implement Keynes’s ideas. Plus my guess is they made a similar hash of it prior to Keynes when trying to reduce national  debts.

H/t to John Cochrane for bringing Rogoff’s paper to my attention.